Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles by email send a blank email to ...

Decide Now Which Funds You Won't Buy

A few weeks ago, the market was tumbling and sentiment dire. Partly to counter the gloom, I wrote a column suggesting that shellshocked readers, whose allocations might have gotten out of whack in the turmoil, take steps to ensure that their portfolios were properly situated for the stock rally that was sure to arrive at some point.

As it turned out, the current rally began the day that column appeared on Morningstar.com. I wish I could claim I'd planned it that way: The invitations to lavish parties at next year's Davos conference would already be pouring in. Unfortunately, in the column I made it clear that I had no idea when a rebound would occur. Oh well.

Anyway, whether or not the current upturn is the real thing, there's an important flip side to the advice in the previous column. Beyond figuring out what you want to be holding, and in what amounts, before a long-term revival comes around, you also should determine what you don't want to own.

Although that might sound unnecessary, deciding what you don't need is a critical task. For if the temptation during a bear market is to avoid thinking about your portfolio--or just go completely into cash--the temptation during a bull market is to chase the hottest sector in order not to miss out on the big prize.

The best way to dodge that temptation is to establish rules beforehand. If you wait until the boom is on, you'll find it extremely difficult to watch passively as the gains posted by some investment or another far surpass those of anything you own. Yet the super performers are inevitably narrowly focused investments that probably didn't merit a place in your investment plan prior to their ascendance and therefore won't deserve one afterward, either.

Building a Chinese WallThe hottest areas of the markets during rallies are typically the riskiest. In that sense, the often-unreliable assumption that one must take higher risks to get higher rewards does pan out. So it's likely that country funds targeting a single high-growth market such as China or Russia, or funds focused on specific sectors such as natural resources or financials (hard to believe, I know) will lead the pack in a future rally as they have in the past. Along with those, some other sectors or fund types that are now obscure (or don't even yet exist) probably will also take a place in the spotlight.

The winners won't just rise a bit more than broader-based funds and indexes. They'll blow them away.

Don't wait until it happens to decide what to do. Decide now, and stick to your guns. If you have decided that your desired portfolio allocation does not include a specific China or natural-resources fund, don't buy one even when they're soaring and seem destined to soar ever higher. Then you won't be one of those unfortunate investors who jumps onto a trend when it's riding high only to lose out when it crashes not long afterward.